Cap-and-Dividend; Better Looking Brother of Cap-and-trade

Economists argue that the optimal method of curbing emissions and thus mitigating climate change is through taxation of products based on the climate changing gases they emit. This tax would be charged to producers and indirectly to consumers through higher prices due to higher costs of production. Higher prices should cause consumption to fall or shift to lower emitting alternatives where they exist causing production to fall. Higher costs for producers should lead them to invest in techniques and technology that reduces emissions. Basically, taxes create incentives that push the market, on both the consumption and production sides, towards lower emissions.

This is all good in theory, however, it is difficult if not impossible to create a political coalition behind raising taxes (and especially taxes on some of the most powerful organisations). Deciding the tax level is also difficult as the costs of emissions are difficult to quantify.

There has been a consensus around the cap-and-trade system. This involves setting a maximum on emissions which will fall yearly. Firms must then buy a permit for each unit of emissions released during production up to the national maximum. The scarcity of permits creates a market with a price that rises when demand for permits rises. There is an incentive for firms to emit less because they then have fewer permits to buy and so relatively lower costs. The ability to sell excess permits also creates a revenue incentive to reduce emissions. The presence of a market helps in price discovery (it could be argued that this is the price firms place on the emissions not society’s however, this is the only objectively determined price).

In practice however, all the cap-and-trade schemes that have been implemented or proposed have had their emission caps set too high and their permits allocated freely. This will have caused the price of permits to remain low (possibly lower than the price needed to incentivise firms) and would weaken the ability of the cap-and-trade scheme to lower emissions.

There’s a new kid on the environmental policy block which I think is pretty good. It achieves the aims of any environmental policy and it’s fair and progressive (woohoo!). It’s Cap-and-Dividend (Naming isn’t really the forte of economists).

Basically, there is a ceiling similar to that above, and permits that will be auctioned off (compulsory for it to work at all). The difference is that the majority of the revenue from the sale of the permits will be distributed on an equal basis to everyone in a country. This is to compensate for the inevitable rise in energy prices. This rise will affect poorer members of society because this increase will be a larger portion of their income than for richer people. The Economist covering a proposal in the US says:

The bill would raise energy prices… and the price of everything that requires energy to make or distribute. But a family of four would receive perhaps $1000 a year, which would more than make up for it… Cap-and-dividend would set a price of carbon, thus giving Americans a powerful incentive to burn less dirty fuel. And it would leave all but the richest 20% of Americans-who use the most energy- materially better off.

I think an important thing to remember is:

1) The simpler a system is, the more likely it is to work. 2) The fairer a system is, the more likely it is to last. 3) In the future, polluters should pay for the right to pollute.